Venture Capital Needs to Downsize or It Will Continue to Stagnate

The venture capital business model is broken, says the
Kauffman Foundation. And the only fix may be to return to the
past  to small, focused funds that are local in nature
and creative in their strategy.

Venture capital funds are simply not delivering, experts now
argue. The ten-year returns for venture funds ending June 30,
2012 averaged 5.3 percent, compared to 6.0 percent for the Dow
Jones Industrial Average and 7.2 percent for the Nasdaq
Composite, reports Cambridge Associates, which tracks
alternative asset performance. For an asset class in which
managers get a 2 percent management fee and 20 percent of the
profits and the capital is locked up for as much as ten years,
the returns are unacceptable, Kauffman and others say. Compared
to other alternative assets such as hedge funds and private
equity funds, venture capital returns often are a poor
third.

In its report We Have Met the Enemy ... And He is
Us, the Kansas Citybased Kauffman Foundation, with
more than 20 years of experience investing in nearly 100
venture capital funds, says venture capitalists have oversold
their importance and value. After a comprehensive analysis of
its own portfolio, Kauffman found a persistent pattern of
inflated early returns that were then used to raise subsequent
funds. The analysis also showed the poor historical performance
of funds with more than $500 million in committed capital.

They point out that the risk has gone out of venture
capital. The staple of legendary venture capitalists such as
Arthur Rock, Georges Doriot and John Doerr was built on
investing in companies such as Apple, Digital Equipment and
Amazon  companies exploring the frontiers of change,
companies too complex for spreadsheets to predict. Today,
we have discarded a century of can-do ambition built on
rapid advances in technology and replaced it with a
cautiousness far too satisfied with incremental
improvements, wrote Paypal founder Peter Thiel and former
world chess champion Garry Kasparov in a recent editorial in
the Financial Times.

Another criticism is that venture capital funds are too big.
The institutional investors that give venture capitalists their
money are too complacent and too undemanding. And the rewards
totally out of sync with performance. The entire incentive
system is off-kilter, says New York investment banker Joe
Cohen, who as the managing partner of Cowen & Co. in the
1980s and 1990s helped take many venture-backed companies. When
the large funds can routinely take in 2 percent fees for just
raising money  the bigger the fund the greater the fees
 there is little incentive to actually perform, says
Cohen.

For the industry to produce competitive returns the asset
class has to shrink, says the Kauffman Foundation. And Cohen
and others believe that institutional investors who invest in
venture capital need to bring the compensation of venture
funds and venture capitalists in line with their actual
performance. Reducing the size of the pool will probably
reduce the number of companies that will receive financing,
but it will boost the return on capital, says Robert Raucci,
an institutional investor himself and a managing partner of
Newlight Partners, a New Yorkbased asset manager.

Raucci believes that the basic tenets of venture capital
are intact and that the asset class still is one of the few
ways to finance a culture of risk and innovation. But the
concentration of capital  geographically and
thematically  has inflated prices to the point that it
is difficult to deliver profit consistently to investors. The
opportunities are lie aboard, or looking at areas within the
U.S. that havent been plowed over, says Raucci.

The Kauffman Foundations biggest criticism is
leveled at institutional investors themselves. Institutional
investors such as endowments and pension funds have distanced
themselves from the task of selecting venture capital by
relying on data crunchers such as Cambridge Associates and
fund-of-funds to make the selections. The process has become
bureaucratic and has been taken over by quants, with the
emphasis on investing in big funds and neglecting outliers,
especially innovative and creative small funds.

We believe LPs have a responsibility to fix
whats broken in the investment model, says Harold
Bradley, the Kauffman Foundations chief investment
officer. Some insiders cry that not enough venture money is
being steered to early-stage companies, he adds. But
until limited partners become more sensitive to small funds
and understand how to accurately rate their potential, the
misallocation will continue.

Many small funds, in spite of their track record, say they
simply cant get through. New Yorks Milestone
Venture Partners Fund II (MVP II) has been among the
best in the industry, big or small. MVP IIs internal
rate of return was 16.9 percent, compared to the -0.33
percent median return for 2001 funds as reported by Cambridge
Associates. More important, MVP IIs performance against
a public market equivalent (PME) as proposed by Kaufman has
been extraordinary. Against the Russell 2000, an index of
small cap companies, which showed a gain of about 4 percent,
MVP IIs returns, net of all fees, were in excess of 17
percent.

Still, Milestone has had a difficult time reaching the
pension funds and endowments. For many institutional
investors we are too small a fund, explains Goodman.
Others continue to insist that Milestone hasnt got a
succession plan in place and hasnt a reliable deal
flow. Many others simply fail to understand the value of the
Milestone portfolio and its potential. Adds Goodman, We
believe that the opportunities for venture investors to
finance young information technology companies with great
growth potential have never been better.

Milestone is experimenting with new models of developing
and financing digital health companies. It recently joined
the New York Digital Health Accelerator (NYDHA), a
collaboration of New York area healthcare companies,
providers and service organizations to fund early stage
digital health ideas. The accelerator selects and finances
projects for nine months, during which time the projects
receive direct access to customers and feedback from the
nearly two dozen healthcare provider organizations that are
in New York. At the end of nine months the projects will be
considered for additional venture financing by funds such as
Milestone.

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